Question 2 (10 marks)

a) A company XYZ Ltd. is considering two potential projects and has the resources to complete at most one of them. The estimated net cash flows for each of the projects occur annually and are shown in the table below. The company will proceed with a project only if it is expected to be profitable on a net present value basis.

Year 0 1 2 3 4

Project A -10,000 -2,000 5,000 5,000 20,000

Project B -8,000 5,000 8,000 5,000 2,000

Use the net present value criterion to decide whether each of the projects is profitable and which project the company should choose, using a discount-rate of 10% p.a. with annual compounding. (5 marks)

(b) Company ABC Pty Ltd considers a potential project with the following estimated net cash flows ($000s):

Year 0 1 2

Project C -10,000 -3,000 14,500

The project would be funded entirely by debt (borrowing) rather than by equity capital. The average borrowing cost for the company for a 2 year project with these risk characteristics is 8% p.a. Calculate the Internal Rate of Return (IRR) for Project C (2 d.p.) and use it to determine whether ABC should proceed with the project. (5 marks)